I was at a meeting today were a banker talked about the different services a business bank could do to help a small business, and it got me thinking about the differences between structured business loans and lines of credit.
Would you know how and when to use loans and lines of credit for your business?
Each is a type of loan, but each has its own pros and cons and used for specific financial strategies and goals for your business.
Let’s start with business loans.
A business loan is commonly used when you have a need to purchase equipment for your business or another tangible item. Of course, the term ‘equipment’ has different meanings for different companies, so let’s break this down a bit more.
When you think of equipment your mind might navigate to something like big earth moving vehicles or large print presses. However, for other small businesses equipment might be something as simple as shelving and racks you need to hold or display your product on; (otherwise labeled as furniture and fixtures). It could also include computer equipment, phone, audio, or cable equipment as well as data servers. Equipment is simply whatever helps your business run and produce its product (or services).
Loans will be for a period of time something like 5 years. A loan will have a recurring monthly payment; the same amount each month will consist of paying some toward the principle of the loan and some to interest. The interest you pay is tax deductible, so make sure the entry to pay the loan payment is broken out to show principle vs interest. The amount to principle will record to your balance sheet and interest amounts will fall under your Admin Expenses.
When getting the loan money distribution this will initially deposit to your checking account, then you will need to set up a new account under current liabilities and name it Loan with the last four numbers of the loan number. The payment to the principal will lower the loan amount by that payment every month and should be reconciled at least quarterly. An annual reconciliation of the the statement from the bank is also needed.
It’s important you talk to an accounting professional before getting a loan and have them help with the bank loan paperwork.
Lines of Credit are different from standard business loans.
A line of credit is a loan type item to help the business with cash flow. Let me say this again this is only to help with your cash flow to keep your business moving forward. It’s a credit limit that stays open and accessible to a business to draw from as long as they meet the terms of the arrangement and obligations. The amount of credit extended will vary based on your current account receivable numbers or your inventory numbers.
Any line of credit will have a maximum amount you can use but you will able to draw from that credit line and pay back the funds any day of the week. So, if you need $2,000 to cover payroll, for example, you can use the money from the line to cover payroll in the short term.
Here is the big thing about lines of credit…
You must pay down the line of credit to zero or close to zero annually. Companies that use their line of credit on a regular basis should have their deposits sweep over to the line of credit. Let me break this down some more…
When you make a sales deposit or receive your credit card payouts you should move that income over to pay down your line of credit right away. This does two things:
- It saves you in daily interest costs, and
- It shows the bank you have the drive to pay this loan down as fast as possible.
This way if you can’t get the balance all the way to zero annually the bank can at least see a history of you consistently trying to pay this revolving credit off. This helps your business in the long run when your banker assesses your credibility to fit you for future business loans.
The bank can set up a weekly or daily sweep of your account to transfer all funds, down to $100.00, in your checking account and then transfer those funds to the line of credit. Some banks may assess an additional fee for this automated service. Otherwise you can manually transfer funds the day after you make a deposit; after it has time to clear the deposit.
When you pay your bills and/or payroll, (twice a month or weekly), you can transfer the money from the line of credit to your business checking account. This is using your available funds to help your business on a daily basis.
If the bank does not see you are using the line of credit correctly, they will not renew the line of credit. They will, instead, convert this credit line into a normal business loan with recurring monthly payments and a pay off date, and you will no longer be able to make additional draws or use the loan as line of credit to help with cash flow in your business.
Bankers also look at how much you have borrowed and what’s available to you. You want to stay under 80% borrowed. If you have a line of credit with $100,000 available, as an example, you don’t want to use more than $80,000 of the credit line at one time. It’s okay to go over once in a while for a short period of time, but nothing long term. Using more than this ratio target frequently will count against you in the bank’s eye. It’s a red flag that you’re unable to manage your budgets and cash flow.
When looking at your bookkeeping and reporting, your line of credit will be placed on the balance sheet under current liabilities and the money will transfer in and out of your checking account register.
Whenever you look at taking out a loan or line of credit be sure to talk to your accountant professional first to help you with the decision making and bank shopping.
Carefree Bookkeeping can help you organize your books for the best results prior to talking to a lender and even put you in touch with local and national lending professionals with unique financing options for your small business, options like Mike Ringdahl from US Bank, for example. Whether you need new equipment, are looking to increase your inventory, marketing, staffing, cover your business through seasonal shifts or you’re looking to make some additional investments… whatever your goal, we can help you get on the right path toward your goals.